Introduction To Financial Economics

Introduction to
Financial Economics
Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-1

The Functions of Finance
•  Transfer money across time periods: Invest and save

(deposits, pension funds, stocks, bonds, etc)
•  Insurance: Transfer funds across states of the world
•  (Re)allocate funds to finance profitable investment

opportunities (Banks, VC, capital markets, etc)

This Class
•  Understanding NPV and using it in simple examples
•  NPV formulas and a bit of fixed income
•  How to think about the determination of the risk-free

discount rate
•  If have time: start to think about NPV in more general

setting.

Administrative Issues
•  Grade = 100% Final
•  Will give out practice homework from time to time
•  Books:
Principles of Corporate Finance, by Richard Brealey, Stewart Myers, and
Franklin Allen, McGraw-Hill Irwin
Corporate Finance, by Jonathan Berk and Peter DeMarzo, Pearson
•  But a non-negligible amount of material not from either

book:
–  Classis Way vs. My Way
–  Will do both

Getting the Units Right: Goods
•  A jewelry manufacturer has the opportunity
to trade 10 ounces of gold and receive 20
ounces of palladium today.
•  Good idea?
•  Obviously, first need to convert them to a

common unit.

Getting the Units Right: Time
•  You run a firm. Can invest $20M today to
obtain a (risk-free) $21M in one year.
•  Good idea?
•  Obviously, first need to convert them to a

common unit.

Interest Rates
and the Time Value of Money
•  Time Value of Money
–  Consider an investment opportunity with the

following certain cash flows.
•  Cost: $100,000 today
•  Benefit: $105,000 in one year
–  The difference in value between money today

and money in the future is due to the time value
of money.

The Interest Rate:
An Exchange Rate Across Time
•  The rate at which we can exchange money today
for money in the future is determined by the
current interest rate.
–  Suppose the current annual interest rate is 7%. By
investing or borrowing at this rate, we can exchange
$1.07 in one year for each $1 today.
•  Risk–Free Interest Rate (Discount Rate), rf: The interest rate
at which money can be borrowed or lent without risk.
–  Interest Rate Factor = 1 + rf
–  Discount Factor = 1 / (1 + rf)

The Interest Rate: An Exchange Rate
Across Time (cont'd)
•  Value of Investment in One Year

–  If the interest rate is 7%, we can express our
costs as:
Cost = ($100,000 today) × (1.07 $ in one year/$
today)
= $107,000 in one year

The Interest Rate: An Exchange
Rate Across Time (cont'd)
•  Value of Investment in One Year

–  Both costs and benefits are now in terms of
dollars in one year, so we can compare them
and compute the investment s net value:
$105,000 − $107,000 = −$2000 in one year
–  In other words, we could earn $2000 more in
one year by putting our $100,000 in the bank
rather than making this investment. We should
reject the investment.

•  Value of Investment Today
–  Consider the benefit of $105,000 in one year.
What is the equivalent amount in terms of
dollars today?
Benefit = ($105,000 in one year) ÷ (1.07 $ in one
year/$ today)
= ($105,000 in one year) × 1/1.07 = $98,130.84
today
This is the amount the bank would lend to us
today if we promised to repay $105,000 in
one year.

•  Value of Investment Today

–  Now we are ready to compute the net value of
the investment:
$98,130.84 − $100,000 = −$1869.16 today
–  Once again, the negative result indicates that we
should reject the investment.

•  Present Versus Future Value

–  Our decision is the same whether we express
the value of the investment in terms of dollars in
one year or dollars today. If we convert from
dollars today to dollars in one year,
(−$1869.16 today) × (1.07 $ in one year/$ today) =−$2000
in one year.
–  The two results are equivalent, but expressed as

values at different points in time.

•  Present Versus Future Value

–  When we express the value in terms of dollars
today, we call it the present value (PV) of the
investment. If we express it in terms of dollars
in the future, we call it the future value of the
investment.

•  Discount Factors and Rate

–  We can interpret
1 1
= = 0.93458
1 + r 1.07
1
as the price today of $1 in one year. The amount is1+ r
called the one- year discount factor. The risk-free rate is
also referred to as the discount rate for a risk-free
investment.

Textbook Example 3.3

Textbook Example 3.3 (cont'd)

Figure 3.1 Converting Between Dollars Today
and Gold, Euros, or Dollars in the Future

Present Value
and the NPV Decision Rule
•  The net present value (NPV) of a project

or investment is the difference between the
present value of its benefits and the present
value of its costs.
–  Net Present Value
NPV = PV (Benefits) − PV (Costs)

NPV = PV (All project cash flows)

The NPV Decision Rule
•  When making an investment decision, take

the alternative with the highest NPV.
Choosing this alternative is equivalent to
receiving its NPV in cash today.

The NPV Decision Rule (cont'd)
•  Accepting or Rejecting a Project

–  Accept those projects with positive NPV because
accepting them is equivalent to receiving their
NPV in cash today.
–  Reject those projects with negative NPV because
accepting them would reduce the wealth of
investors.



Choosing Among Alternatives
•  We can also use the NPV decision rule to

choose among projects.
•  To do so, compute the NPV of each

alternative, and select the one with highest
NPV.
•  This alternative is the one which will lead to

the largest increase in the value of the firm.



Table 3.1 Cash Flows and NPVs for
Web Site Business Alternatives

NPV and Cash Needs
•  But what about preferences for consumption?!
•  “Hiring a manager” is highest NPV, but requires

outlay of $50K. Suppose you needed $60K to pay
for school?
•  Regardless of our preferences for cash today

versus cash in the future, should always
maximize NPV first. Can then borrow or lend
to shift cash flows through time and find most
preferred pattern of cash flows.

Table 3.2 Cash Flows of Hiring and
Borrowing Versus Selling and Investing

Arbitrage and the Law of One Price
•  Arbitrage
–  The practice of buying and selling equivalent
goods in different markets to take advantage of
a price difference. An arbitrage opportunity
occurs when it is possible to make a profit
without taking any risk or making any
investment. (Will provide a more formal
definition later on)
•  Normal Market
–  A competitive market in which there are no
arbitrage opportunities.

Arbitrage and the Law of
One Price (cont'd)
•  Law of One Price

–  If equivalent investment opportunities trade
simultaneously in different competitive markets,
then they must trade for the same price in both
markets.

No-Arbitrage and Security Prices
•  Valuing a Security with the Law of One

Price
–  Assume a security promises a risk-free payment
of $1000 in one year. If the risk-free interest
rate is 5%, what can we conclude about the
price of this bond in a normal market?
PV ($1000 in one year) = ($1000 in one year) ÷ (1.05 $ in one year / $ today)
= $952.38 today
•  Price(Bond) = $952.38

Identifying Arbitrage
Opportunities with Securities
•  What if the price of the bond is not $952.38?
–  Assume the price is $940.
–  The opportunity for arbitrage will force the price of the

bond to rise until it is equal to $952.38.

Identifying Arbitrage
Opportunities with Securities
•  What if the price of the bond is not $952.38?
–  Assume the price is $960.
–  The opportunity for arbitrage will force the price of the

bond to fall until it is equal to $952.38.

Determining the No-Arbitrage
Price
•  Unless the price of the security equals the
present value of the security s cash flows,
an arbitrage opportunity will appear.
•  No Arbitrage Price of a Security
Price(Security) = PV (All cash flows paid by the security)
•  In a normal market, what is the NPV for a

firm of buying a stock (say Apple Inc.) at
the market price?



Valuing a Portfolio
•  The Law of One Price also has implications

for packages of securities.
–  Consider two securities, A and B. Suppose a
third security, C, has the same cash flows as A
and B combined. In this case, security C is
equivalent to a portfolio, or combination, of the
securities A and B.
•  Value Additivity
Price(C) = Price(A + B) = Price(A) + Price(B)

Where Do We Go From Here?
•  Impact of Risk on Valuation
–  When cash flows are risky, we must discount
them at a rate equal to the risk-free interest
rate plus an appropriate risk premium.
–  The appropriate risk premium will be higher the
more the project s returns tend to vary with
overall risk in the economy.
•  But still need

–  some terminology, common framework, etc
–  How is risk free rate determined?
Where Do We Go From Here?
•  How is risk free rate determined?
•  Supply and demand for investment in GE:

See accompanying pdf…

Three Rules of Time Travel
•  Financial decisions often require combining

cash flows or comparing values. Three rules
govern these processes.
Table 4.1 The Three Rules of Time Travel

The 1st Rule of Time Travel
•  A dollar today and a dollar in one year are

not equivalent.
•  It is only possible to compare or combine
values at the same point in time.
–  Which would you prefer: A gift of $1,000 today
or $1,210 at a later date?
–  To answer this, you will have to compare the
alternatives to decide which is worth more. One
factor to consider: How long is later?

The 2nd Rule of Time Travel
•  To move a cash flow forward in time, you

must compound it

The 2nd Rule of Time Travel
(cont d)
•  Future Value of a Cash Flow

Figure 4.1 The Composition of
Interest Over Time


Textbook Example 4.2 (cont d)

The 3rd Rule of Time Travel
•  To move a cash flow backward in time, we

must discount it.
•  Present Value of a Cash Flow
n C
PV = C ÷ (1 + r ) =
(1 + r )n



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Introduction to

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-1

• Transfer money across time periods: Invest and save

• Insurance: Transfer funds across states of the world

• (Re)allocate funds to finance profitable investment

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-2

• NPV formulas and a bit of fixed income

• How to think about the determination of the risk-free

• If have time: start to think about NPV in more general

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-3

• Will give out practice homework from time to time

• But a non-negligible amount of material not from either

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-4

• Obviously, first need to convert them to a

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-5

• Obviously, first need to convert them to a

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-6

• Time Value of Money

– Consider an investment opportunity with the

– The difference in value between money today

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-7

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-8

• Value of Investment in One Year

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-9

• Value of Investment in One Year

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-10

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-11

• Value of Investment Today

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-12

• Present Versus Future Value

– The two results are equivalent, but expressed as

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-13

• Present Versus Future Value

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-14

• Discount Factors and Rate

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-15

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-16

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-17

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-18

• The net present value (NPV) of a project

NPV = PV (Benefits) − PV (Costs)

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-19

• When making an investment decision, take

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-20

• Accepting or Rejecting a Project

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-21

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-22

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-23

• We can also use the NPV decision rule to

• To do so, compute the NPV of each

• This alternative is the one which will lead to

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-24

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-25

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-26

Copyright ©2014 Pearson Education, Inc. All rights reserved. 4-27

• But what about preferences for consumption?!

• “Hiring a manager” is highest NPV, but requires

• Regardless of our preferences for cash today

•  Transfer money across time periods: Invest and save

•  Insurance: Transfer funds across states of the world

•  (Re)allocate funds to finance profitable investment

•  NPV formulas and a bit of fixed income

•  How to think about the determination of the risk-free

•  If have time: start to think about NPV in more general

•  Will give out practice homework from time to time

•  But a non-negligible amount of material not from either

•  Obviously, first need to convert them to a

•  Obviously, first need to convert them to a

•  Time Value of Money

–  Consider an investment opportunity with the

–  The difference in value between money today

•  Value of Investment in One Year

•  Value of Investment in One Year

•  Value of Investment Today

•  Present Versus Future Value

–  The two results are equivalent, but expressed as

•  Present Versus Future Value

•  Discount Factors and Rate

•  The net present value (NPV) of a project

•  When making an investment decision, take

•  Accepting or Rejecting a Project

•  We can also use the NPV decision rule to

•  To do so, compute the NPV of each

•  This alternative is the one which will lead to

•  But what about preferences for consumption?!

•  “Hiring a manager” is highest NPV, but requires

•  Regardless of our preferences for cash today

•  Law of One Price

•  Valuing a Security with the Law of One

–  The opportunity for arbitrage will force the price of the

–  The opportunity for arbitrage will force the price of the

•  In a normal market, what is the NPV for a

•  The Law of One Price also has implications

•  But still need

•  Supply and demand for investment in GE:

•  Financial decisions often require combining

•  A dollar today and a dollar in one year are

•  To move a cash flow forward in time, you

•  Future Value of a Cash Flow

•  To move a cash flow backward in time, we

•  Present Value of a Cash Flow